How The Times Change...

Assume that you are looking at a company in 2005 with the following characteristics: it reported revenue of just over $39.5 billion, and net income of $1.07 billion (net margin of 2.7%); now fast forward to 2011, and look at that same company in the heart of a global economic slowdown – sales for the fiscal year came in at $43.6 billion (1.66% CAGR) and net income was up slightly to $1.12 billion (net margin of 2.6%).

You know that this company has been hurt by unemployment (and that key markets are materially worse off in this metric compared to the starting period), but expect that an eventual recovery in certain markets around the globe will act as a tailwind for the business. As far as headwinds go, the company is facing some structural changes and intensified competition, though not from anyone beyond competitors that were ferociously fighting for share in 2005 as well.

With this information, what would you be willing to say about the relative value of this corporation - more attractive in 2005, more attractive in 2011, or just about the same in both periods?

In reality, this isn’t a single company - it’s the collective results of the three main U.S. office supply chains: Staples (SPLS), Office Max (OMX), and Office Depot (ODP). Looking at the results for both years, I would assume the consensus is that while the slight contraction in net margin is concerning, the ability to continue driving sales growth (albeit slowly) in the heart of the worst economic crisis since the Great Depression is a plus; as a result, I would conclude that there’s little to suggest that intrinsic value has moved materially in either direction.

The market, on the other hand, doesn’t seem to agree: in 2005, these companies had a collective market capitalization of $25 billion; Mr. Market was willing to pay 24x earnings for a company facing structural headwinds (the negative impact of computers, email, etc on paper and ink sales was widely anticipated) and intensifying competition from a growing e-commerce industry. Fast forward six years (and into the heart of double digit unemployment around the globe), and it appears that the industry has (collectively) navigated this environment with some success – except now Mr. Market is only willing to pay $8.4 billion, or one-third of the previous amount, for a comparable level of earnings.

This isn’t to conclude that these companies are currently undervalued; all I’m trying to do is point out something that is often overlooked – the threats facing these companies are identical to what they were half a decade ago. Some people believe that this industry is all but dead, that it will not be able to stand up to Wal-Mart (WMT) and Amazon (AMZN) – and they point to a stock price that forecasts disappearing earnings and other troubles ahead as evidence; personally, I think using stock prices as justification for such beliefs rather than the financials (which suggest something quite different) is illogical (particularly if one is active in the markets, and thus by deduction believes inefficiencies do exist).

My point is this: the market was willing to pay a rich premium during the heights on an economic boom (essentially implying that the good times would continue), yet will pay just a third of the previous price for the same dollar amount of earnings in the depths of a recession (essentially implying that the bad times will not only continue, but intensify); for the individual that can keep a level head while others are dancing between bouts of euphoria and despair, I think the fundamentals point to a sweet spot somewhere in the middle.

About the author:

The Science of Hitting

I'm a value investor with a long term focus.

As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "Patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.

The true worth possibly lies some where in between. Clearly the 2006 valuation was too high on an absolute basis. The current valuation looks low on the trailing basis. However, the companies are in a mature and out of favor industry and facing competition. That has compressed multiples drastically. If the leader is able to out last the other weaker players and take some tough choices, the true value may be assigned. (Hint :Any chance of shutting down Europe operations? or does that not make sense?) Shrink the capital. Use it to pay off debt ?

I am also adding SPLS every time it went down. At the current price, i got 18% and 42% margin of safety from my P/E and FCF valuation. Moreover, i got Piotroski F-score of 9.00 (means strong company; low probability of bankruptcy) and Altman Z-score of 3.93 (means safe; bankruptcy unlikely). Thanks for your writeup.

the financials only report the past - so, earnings may not be as reliable if the competitive landscape gets worse; but this is stating the obvious - i think the article would've been more informative if the competitive position was analysed more thoroughly and translated to a range of earnings estimates over next five years or so.

That's a good question; in the case of SPLS, we will hear management's thoughts on those items on the Q3 call...

Patience,

Agreed; I don't know how low this can go, but if the fundamentals are unchanged I'll be there the whole way down.

Graham,

That's partly the point: this idea that the fundamentals have changed so drastically in the course of five years is materially overstated in my opinion - particularly when one considers the industry and the affect the economy (particularly unemployment in sectors like financials and government, which have been hit the hardest) has had on it. Any analysis of the competitive environment (beyond SPLS vs OMX vs ODP) is difficult because Amazon, Wal-Mart, etc tell us little/nothing about their sales by category. With that being said, I've come across some interesting ecommerce sales data - which I will present in an article relatively soon.

Is it possible office supply stores are in the early stage of secular decline because competitive dynamics have changed and business economics are deteriorating? Five to ten years from now, how big is the threat of amzn and wmt to spls/omx/odp? Several years from now, is it likely that office supply stores will be in dire strait like tech/electronics stores such as circuit city, rsh, bby, gme are in now? Unless I can understand future competitive advantages of office supply stores, I wouldn't bet my money on their future profit margin or survivability.

Hi Science of Hitting, sorry but I think there is a major flaw in your point. You saying that these companies are as much valuable today as they were some years ago...let's say you're right you still didn't prove that these companies are cheap today. Couldn't it be that they were overpriced by the market back then and that now they're just fairly valued?or maybe still expensive?! What I mean is that until you delve into fundamental analysis you won't find an answer, there's no such a shortcut.

Read the second to last paragraph in the article; I essentially made the exact point you addressed: I didn't say they were much more valuable, I just find it interesting that the market would pay 3x back then compared to today, yet were at a higher level of sales and profitability; that doesn't mean these companies were worth the market price back then - it's simply food for thought that should make anyone question the markets ability to jump from euphoria to "this industry is dead".

Stockdocx99,

There's no arguing with the fundamentals - but most people let the stock price tell them how the business is doing, not the financial statements.

Nicolas73,

Staples internet business had roughly $10B in sales in 2010, making SPLS the second largest internet reseller in the world (behind Amazon).

I made a lot of money-losing mistakes by looking at impressive historical growth data and bought dominating companies at historical low price. The major flaw of these investments is that I believe in data and buy at historical low price without thinking and understanding shift in competitive landscape and change in economics of business.

These are numbers of BBY from Valueline and they are no less impressive than SPLS,

Could you envision two years ago that BBY (2010 price low-hi 30.9-48.8) would have been in such dire situation now? Can you think up some scenarios that SPLS will be in a dismal state two years down the road, similar to BBY is in now?

I'll present my comparison between BBY and SPLS in the near future, but looking at the business mix is a good place to start; Staples Delivery business is in no way comparable to any part of BBY's consumer retail business.

Hi, thank you everybody for your answers. Well I didn't say that Staples didn't add value in the last 4 years, my point was that price and multiple comparisons doesn't necessarily lead to good investment decisions they're only a proof for market exuberance.... Talking about valuation I don't think it's an expensive stock on an OE basis but I wouldn't either buy it cause I don't know if it's a defendable business, will they keep buying stuff at Staples will they turn to some more efficient online vendors like Amazon? AMZN is a serious concern not just an emotional bias cause they can turn inventory 12X and they not interested in making profits in the near future...You can't stand up against dumping.

So...I don't know if it's cheap or it will get cheaper all the way down....

Those numbers are taken right out of latest Valueline BBY page dated Aug 3, 2012. Is your "Value Line" page different from mine?

Looking 5 to 10 years down the road, can you enumerate the moats around SPLS to guard against AMZN, WMT and other competitive forces?

I am still learning how to navigate treacherous investment landscape by not only looking at rear-view mirrors. The view through windshield is always hazy and uncertain, but you need to look ahead to avoid disasters.

In investing, I am always looking for disconfirming evidences and try to kill my best ideas. I prefer to ruthlessly challenge my investment thesis before committing funds than licking my wounds and regretting afterward. If you have convincing evidences that SPLS possesses sustainable moats I will go with you and put my money on the line.

Retail businesses are very brutal and profit margin may disappear in a short order. Just look at RSH and BBY in the last two quarters. On-line stores can deal grave damages to retailers that compete with them. In addition, Bezos reiterates year after year he does not care short-term (In his eyes, it can be 10 or more years) profitability. I would be sleepless competing with AMZN in the next ten years.

Definitely, SPLS is different from BBY. BBY is no less dominating player in it's field than SPLS in office supply. It caught my attention when SPLS price dropped ~15% less than 2 weeks ago and I studied it's financial reports. SPLS rear-view mirror numbers look great to me just like BBY several quarters ago. The concern I have is what are SPLS's moats? If there are moats, are they growing, shrinking, or disappearing. Looking back at my investments, I have lost money in most cases when I bought into no-moat or shrinking-moat businesses even at low price vs valuation (P/E, P/CF, P/S, P/B).

I would like you or SoH to present your thought on 5-10 year competitive advantages of SPLS, especially against AMZN.

I'll address the BBY comparison in an upcoming article, but I would start by pointing you to the delivery business (60% OF SALES), which is materially different than the consumer retail business; I would also suggest that you look at the dynamics of the retail office supply competition, where OMX & ODP have announced multi-year downsizings/closures that will come on line in a big way starting in 2012 - this will have a material impact on the store level economics for remaining competitors (as I've noted, sales are not disappearing at a rapid pace despite a global economic crisis).

In terms of competitive advantages over Amazon at that retail business, that's a bit more difficult to answer (and a question for all retailers) - while Staples certainly outsells AMZN (in terms of office supplies), how do you compete with someone who does not care about profitability? (By the way, people suggest this is a near term choice, like one day AMZN can simply bump up pricing and consumers will not look for alternatives in an increasingly transparent pricing environment - I think WMT might have different ideas about how this plays out).

I think the answer involves a focus on services (which SPLS has done), maintaining flexibility (the ability to resize/close stores as needed), and maintaining the perception of price comparability (SPLS has price match, but has not done a good enough job letting the consumer know about it). I will go further into these areas in the near future, but think that's a general outline for a specialized retailer in the age of ecommerce.

Has anyone looked at the amount of stock compensation this company expenses annually? It seems excessive to me, which is enough reason (for me, at least) to avoid the company despite the attractive valuation.

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